I Love Dividends — but I Refuse to Fall Into This Trap

There’s a reason so many investors are big fans of dividend stocks: When you buy shares of dividend stocks, you get two opportunities to make money.

First, you can collect your dividends and reinvest them to fuel your portfolio’s growth. Secondly, as is the case with all stocks, dividend-paying stocks have the potential to gain value over time. You might buy shares at $200 a pop, and if you hold them for many years, they may be worth $400 apiece down the line.

I happen to own shares of a number of dividend-paying companies in my portfolio. Some of those are REITs, or real estate investment trusts, which are actually required to pay at least 90% of their taxable income as dividends, and, as such, commonly have higher dividend yields than your average stock.

Image source: Getty Images.

But I also tend to take a very cautious approach when it comes to investing in companies that pay dividends. And you may want to do the same.

Look at the big picture

A high dividend yield can be tempting. After all, that’s income you can hope to see in your portfolio on an ongoing basis. But one trap you don’t want to fall into when loading up on dividend stocks is focusing solely on dividends and not on a company’s financial health.

It’s easy to assume that a company paying a large dividend is doing well financially. But that’s the same thing as saying that your neighbor with the $120,000 sports car must be in great financial shape. For all you know, that neighbor has a stack of credit card bills the size of Mount Everest and has missed his last three mortgage payments.

Granted, it’s easier to gauge the financial health of a publicly traded company than that of a showy neighbor. Your neighbor isn’t required to tell you how much money he has in the bank and what his debts look like, whereas publicly traded companies are subject to strict disclosure requirements on the part of the SEC.

But some investors get so caught up in chasing dividends that they don’t take the time to look at that information and see how well (or not) the companies behind them are doing. And that’s a mistake that can be very costly.

As such, my rule for investing in dividend stocks goes something like this: First, I ask myself whether I think the business in question is a good one and a smart investment. If the answer, based on my research, is yes, I then take a look to see what sort of dividend, if any, the company is paying.

But to be clear, I look at those dividends as gravy. I don’t base my decisions on them. And that’s a route you may want to take, too.

Dividends can change over time

If you focus too heavily on dividends over company strength, you might end up putting your money into stocks that underperform. But that’s not the only reason to not get too hung up on dividends. Another big reason is that dividends aren’t set in stone.

A given company might pay a 5% quarterly dividend now. That doesn’t mean it will keep paying that dividend indefinitely.

Companies have the right to shrink their dividends as they see fit. They can even eliminate them completely. So rather than base your investing decisions on dividends, find quality businesses that fit nicely into your portfolio. If those businesses happen to pay solid dividends, even better.

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